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Working%20 paper%20249

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Working Paper No. 249 The Service Sector as India’s Road to Economic Growth? Barry Eichengreen Poonam Gupta April 2010INDIAN COUNCIL FOR RESEARCH ON INTERNATIONAL ECONOMIC RELATIONS

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ContentsForeword ......................................................................................................................... iAbstract ..........................................................................................................................ii1. Introduction ............................................................................................................... 12. Growth and Structural Transformation in International Perspective ........................ 23. Where is Service-Sector Growth Concentrated? ...................................................... 44. International Comparisons ........................................................................................ 55. Accounting for Service Sector Growth ..................................................................... 66. Proximate Determinants of Service Sector Growth .................................................. 97. Employment in Services ......................................................................................... 108. Conclusion .............................................................................................................. 11References .................................................................................................................... 13Appendix A: Issues Related to Measurement and Quality of the NAS Data ............. 15Appendix B: Data Sources .......................................................................................... 21Appendix C: Construction of Services Characteristics............................................... 22Appendix D: Correlation Between Growth Across Sectors ....................................... 23 List of TablesTable 1: Characteristics of Different Services ............................................................ 34Table 2: Growth Rates and Sectoral Shares of Different Services in India ................ 35Table 3: Service Input per unit of Output in Agriculture and Industry in India ......... 36Table 4: Explaining the Growth in Services in India .................................................. 36Table 5: Employment Elasticity in India using the data from the NSS ...................... 37Table 6: Employment Elasticity of Growth in Different Service Activities in Cross Country Data ................................................................................................ 38 List of FiguresFigure 1: Shares of Agriculture, Industry and Services in India................................. 24Figure 2: Sectoral Growth Rates .................................................................................. 24Figure 3: Services Sector Share in GDP and Log Per Capita Income ........................ 25Figure 4: Industry’s Share in GDP and Per Capita Income ........................................ 25Figure 5: Size of Specific Services in India ................................................................ 26Figure 6: Size of Service Activities in Different Groups ............................................ 27Figure 7: Contribution of Various Services to Total Services Growth ....................... 28Figure 8: Size of Different Service Activities and Per Capita Income-Cross Country Experience and India ................................................................................... 29Figure 9: Different Uses of Services as per cent of Total Services ............................ 30Figure 10: Different Uses of Services as Per Cent of Total Services Value Added across Countries ........................................................................................... 30Figure 11: Exports of Services .................................................................................... 31Figure 12: Composition of Services Exports from India ............................................ 31Figure 13: Composition of Exports of Miscellaneous Services.................................. 32Figure 14: Services Growth in India Attributed to Growth in End Use ..................... 32Figure 15: Share of Different Services groups in GDP and Employment .................. 33

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ForewordIndia holds a reputation of cultivating a large and dynamic services sector centeredmostly on information and communications technology. The quality and sustainabilityof its services sector are nonetheless questioned by some sceptics on the grounds thatthe rapid growth of service sector employment simply reflects a relabelling ofactivities previously conduc in house by manufacturing firms. conductedIn this paper, Barry Eichengreen and Poonam Gupta analyze the determinants ofgrowth in the services sector and assess the employment generating capacity of employment-generatingservices in India. They find that there is an increasingly similar mix of skilled skilled-unskilled labor in the services and manufacturing sectors. They ask whether Indiashould continue exploiting its comparative advantage in services instead of followingthe usual route to economic growth in the process of economic development –whichconsists in building-up labour up labour-intensive manufacturing–, or if these two approaches ,are in fact complementary strategies for enhancing economic growth and raisingliving standards in the country. (Rajiv Kumar) Director and Chief ExecutiveApril 20, 2010 i

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AbstractAmong fast growing developing countries, India is distinctive for the role of theservice sector. However, sceptics have raised doubts about both the quality andsustainability of the increase in service sector activity and its implications foreconomic development. Using National Accounts Statistics and cross-county data, weshow that the growth of services has been broad-based. We show that the growth ofservice sector employment is not simply disguised manufacturing activity. We alsofind that the skilled-unskilled mix of labour in the two sectors is becomingincreasingly similar. Hence, it is no longer obvious that manufacturing is the maindestination for the vast majority of Indian labour moving into the modern sector andthat modern services are only a viable destination for the highly skilled few. To theextent that the expansion of both modern manufacturing and modern services isconstrained by the availability of skilled labour, this just underscores the importancefor India of continuing to invest in labour skills. We conclude that sustainingeconomic growth and raising living standards will require shifting labour out ofagriculture into both manufacturing and services and not just into one or the other._______________________________Keywords: Services, Growth, Structural change, India, EmploymentJEL Classification: O10, O11, O14 ii

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The Service Sector as India’s Road to Economic Growth? 1 Barry Eichengreen and Poonam Gupta1. IntroductionAmong fast growing developing countries, India is distinctive for the role of theservice sector. Where earlier developers grew on the basis of exports of labour-intensive manufactures, India has concentrated on services. Although there are otheremerging markets where the share of services in GDP exceeds the share ofmanufacturing, India stands out for the size and dynamism of its service sector.Sceptics have raised doubts about both the quality and sustainability of the increase inservice sector activity. They have observed that employment in services isconcentrated in the informal sector, personal services and public administration,activities with relatively little scope for productivity improvement and limitedspillovers. They downplay information technology and communications-relatedemployment on the grounds that these sectors are small and use little unskilled labour,the implication being that a labour-abundant economy cannot rely on them to movepeople out of low-productivity agriculture.2 They worry that the rapid growth ofservice sector employment simply reflects the outsourcing to service sector providersof activities previously conducted in house by manufacturing firms; in other words, itis little more than a relabelling of existing employment than new jobs. They thusquestion whether shifting labour from agriculture directly to services confers the samebenefits, in terms of productivity growth and higher living standards, as the moreconventional pattern of shifting labour from agriculture to manufacturing in the earlystages of economic development.In this paper, we use National Accounts Statistics (NAS) and cross-country data fromthe World Development Indicators and EUKLEMS to address these issues.3 Weestimate the relative importance of final consumption, intermediate consumption andexports as sources of demand for services. Drawing evidence from the experience ofother countries, we attempt to infer the employment-generating capacity of services inIndia.We find that the growth of services in India has been broad-based, although it hasbeen unusually rapid in modern services like communications, business services andfinancial services. In practice, services that are tradable internationally have grownfastest.41 University of California, Berkeley and Indian Council for Research on International Economic Relations (ICRIER), Delhi, respectively. Comments are welcome at eichengr@econ.Berkeley.EDU and pgupta@icrier.res.in2 See e.g. Acharya (2003) and Panagariya (2008).3 Gupta and Gordon (2001), Mattoo and Mishra (2001), Bosworth, Collins and Virmani (2007) have raised doubts about the quality of the National Accounts Statistics (NAS) data used to compare the growth of the agricultural, industrial and service sectors. We discuss data related issues in detail in Appendix A and suggest ways to improve it.4 Service-sector exports have also held up slightly better than merchandise exports in the crisis, reflecting lesser effects from the disruption of trade credit and the absence of sharp inventory adjustments like those affecting sectors involved in commodity trade. The resilience of services trade 1

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We reject the claim that the growth of the service sector is simply disguisedmanufacturing activity. Only a small fraction of the growth of demand, in fact, derivesfrom the outsourcing of activities from manufacturing to services. Rather, mostproduction that does not go towards exports derives from the growth of final demandat home. The growth of service-sector employment does more to add to totalemployment outside agriculture than outsourcing arguments would lead one to expect.This suggests that policy makers should continue to encourage exports of IT,communications, financial and business services while also liberalising activities likeeducation, health care and retail trade where regulation has inhibited the ability ofproducers to meet domestic demand.Finally, we observe that the skill content of labour employed in both manufacturingand in services is increasing and shows tendencies towards convergence. It is not as ifmanufacturing employs only low-skilled labour while modern services employ onlyhigh-skilled labour. Both sectors are moving towards the employment of skilledlabour; the skilled-unskilled mix of labour in the two sectors is becoming increasinglyalike. Hence, it is no longer obviously the case that manufacturing is the exclusivedestination for the vast majority of Indian labour moving into the modern sector andthat modern services are a viable destination only for the highly skilled few. To theextent that the expansion of both modern manufacturing and modern services isconstrained by the availability of skilled labour, this just underscores the importancefor India of continuing to invest in labour skills.5We conclude that sustaining economic growth and raising living standards willrequire shifting labour out of agriculture into both manufacturing and services, notjust into one or the other. The argument that India needs to build up labour-intensivemanufacturing and the argument that it should exploit its comparative advantage inservices are often posed in opposition to one another. We argue, in contrast, that thesetwo routes to faster growth and higher incomes are complements, not incompatiblealternatives.2. Growth and Structural Transformation in International PerspectiveWe start by viewing the evolution of sectoral shares in India from an internationalperspective. Figure 1 displays the shares of agriculture, industry and services in GDP.It shows how the share of agriculture (the dashed line) has fallen from 55 per cent in1950-51 to less than 18 per cent in 2007-08.6 The steadiness of the decline is its mosteye-catching feature. The rise of industry, in contrast, has been episodic. The share ofmanufacturing rose rapidly in the first 15 post-independence years, reflecting Nehru’semphasis on heavy industry, but more modestly from the mid-1960s through to the is not specific to India but seems to be present in other countries as well. Borchert and Mattoo (2009) show that services exports and imports have fallen less sharply in the US, OECD countries, and India and China in the current global slowdown. They also show that the trade of services, which are related closely with goods trade, such as transport and financial services, has declined more sharply than the trade of professional and business services (the latter even increasing in some instances).5 Though manufacturing perhaps relies more on infrastructure and is affected more by labour laws than services.6 CSO, the main source of data for GDP and sectoral growth rates, defines agriculture as including forestry and fishing; and industry as encompassing manufacturing, electricity, gas and water, mining and quarrying and construction. Year 2007-08 refers to April 2007-March 2008 in India or fiscal year 2008. 2

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early 1990s. Following an increase at the outset of the 1990s, reflecting a wave ofliberalisation, industry’s share then stagnated. Meanwhile, the share of the servicesector increased from 30 per cent of GDP in 1950 to 55 per cent in 2007-08, rising atan accelerating pace as the period progressed.Figure 2 shows the average growth rates of agriculture, services, manufacturing andindustry over these periods. It reveals even more clearly how the growth rate ofservices has accelerated while that of agriculture has declined.7Next, we show the shares of services and industry in GDP at different levels of percapita income in different countries. We estimate the relationship between the shareof services in GDP and per capita income as a quartic polynomial in log per capitaincome for a sample of some 80 countries for 1950-2006.8 We show the respectivetwo standard deviation bands and distinguish the periods 1950-1969, 1970-1989, and1990-2006.Based on these regressions, the service sector appears to grow in two waves (seeFigure 3). In the first wave, its share of output rises but at a decelerating pace,levelling out at a per capita income of $1,800 in year 2000 US purchasing-power-parity dollars. In the second wave, the share of the service sector begins climbingagain at a per capita income of roughly $4,000 before levelling off again. Theevidence also suggests that the second wave starts at lower incomes after 1990 thanbefore.9Against this backdrop, we superimpose the observations for India (in dots). Evidently,the Indian service sector was stunted all through the 1950-1990 period with the gapwidening after 1960. Although the share of services rose rapidly starting in the 1980s,India continued to lag the international norm. After 1990, there was then rapidconvergence to the predicted level. By 2005, the share of India’s service sectorincreased to a level significantly above that predicted by the international crosssection for a country with its level of per capita income.Figure 4 is the analogous relationship for industry.10 It shows that the share ofindustry rises rapidly at low incomes, peaking at around 40 per cent of GDP and an7 Contrary to the perception of poor industrial sector performance, the growth of industry has in fact averaged 6-7 per cent since 1990, and even higher since the turn of the century. Manufacturing (industry net of mining and quarrying, electricity, gas, water and construction) has grown by a robust 8 per cent a year during 2000-2007.8 Regressions include country fixed effects, and allow for different intercepts in 1970-1989 and in 1990-2006; and a different slope in 1990-2006 (for details see Eichengreen and Gupta (2009)). The data are from the World Development Indicators, which defines, consistent with the CSO, agriculture as agriculture, forestry and fishing; and industry as manufacturing, electricity, gas and water, mining and quarrying and construction.9 The evidence also shows that this two-wave pattern and specifically the greater importance of the second wave in medium-to-high-income countries is most evident in democracies, in countries that are close to major financial centres, and in economies that are relatively open to trade (and especially to trade in services). See Eichengreen and Gupta (2009).10 The estimated size of share of industry in GDP is based on a cubic polynomial relationship between the industry share and log per capita income. As before, regressions include country fixed effects and allow for different intercepts in 1970-1989 and in 1990-2006; and a different slope in 1990-2006. The behaviour of agriculture’s share in GDP in India is unexceptional. It is right on top of the 3

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income level of $8,000 (in year 2000 US purchasing power parity dollars). Evidently,the share of the industrial sector has tended to peak at a lower level of per capitaincome over time. The observations for India suggest that until the mid-1990s, theindustrial sector was larger than the international norm. Since then, the pace of growthin industry has been the same as that of overall GDP, thus keeping the share ofindustry stagnant. The relatively low share of manufacturing in India has beenbemoaned for failing to provide an alternative to agriculture; these charts provide ahint that services have helped to pick up the slack.3. Where is Service-Sector Growth Concentrated?Some observers worry that the growth of services is concentrated in the informalsector, personal services, and public administration, activities with little scope forproductivity improvement and with limited spillovers. To shed further light on thesepatterns, we distinguish three groups of services according to whether their shares inGDP in the OECD countries have fallen, risen slowly, or risen rapidly.11 Group 1 ismade up of traditional services – retail and wholesale trade, transport and storage,public administration and defence – whose share in GDP has fallen in the advancedcountries. Group II is a hybrid of traditional and modern services consumed mainlyby households – education, health and social work, hotels and restaurants, and othercommunity, social and personal services – whose shares rise linearly with per capitaincome and slowly with time, and linearly with per capita income. Group III is madeup of modern services consumed by the household and corporate sectors – financialintermediation, computer services, business services, communications, and legal andtechnical services – whose share in GDP in the OECD countries has risen rapidly.12Productivity growth has been the highest, predictably, in Group III (Table 1). Moresurprisingly, productivity increases have also been relatively rapid in Group I, someof whose components such as retailing and wholesaling have made extensive use ofIT.13 The presumption, then, is that the decline in the share of output accounted for byGroup I reflects a relatively low income elasticity of demand. It is in Group II wherethe cost-disease problem (the low productivity growth sometimes thought to becharacteristic of services) appears to be the most serious.Service-sector growth is widespread across activities (Figure 5). However, the fastestgrowing are business services, communication and banking, all of which belong toGroup III. Business services, which include computer-related services, machineryrental, accounting, legal services, technical services, and research, of which computerservices (which accounted for about four-fifths of business services in 2005-06) is thesingle fastest-growing segment. Financial services include banking and insurance,with banking being the largest and fastest growing. Other rapidly growing sectors predicted downward sloping relationship with respect to income. To save space, we do not show the figure for the share of agriculture here.11 Gordon and Gupta (2004) working on similar Indian data divided the services sector into two groups, the trend growers and the fast growers. The group of trend growers matched roughly with services included in group I here and fast growers included activities in groups II and III here.12 For details on the growth and shares of different activities in OECD countries in these three groups, see Eichengreen and Gupta (2009).13 Suggestively, Group II ranks lowest in terms of the application of information technology. It also has the least tradability, suggesting that limits on international competition and scope for specialisation may be further factors in its low productivity growth. 4

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include hotels, restaurants, education, health (all Group II), and trade and transport(Group I). The transport sector includes road transport, railway transport, air transportand water transport. The most dynamic of these is road transport, which increased six-fold between 1991-92 and 2005-06.14 The stagnant service sectors in India have beenpublic administration and defence, whose growth seems to have levelled off, andmiscellaneous other personal services (Table 2).15Figure 6 shows that the share of Group I services stagnated following an early periodof rapid growth. By contrast, the share of Group II continued growing steadily, whilethat of Group III has accelerated since 1990. On balance, then, India has been movingin the direction of higher-tech services.Some observers have dismissed the growth of modern services on the grounds thatthese activities are small as a percentage of GDP and, therefore, can contribute onlymodestly to the growth of GDP. To test this hypothesis, we multiply the share of eachservice category in GDP by its growth rate. The results, in the left panel of Figure 7,indicate that the contribution of communication, business services, financial services,education, health and hotels and restaurants has in fact risen to the point where itaccounted for more than four percentage points of growth to services (roughly half oftotal growth) in 2000-06.16 These activities alone explain most of the acceleration inservices sector growth. The contribution of trade, transport and public administrationand defence to services growth has remained stable at 3.5 percentage points since1980s, indicating that these activities have not played a role in the growth accelerationof service sector activity.4. International ComparisonsWe now compare the growth of our three categories of services in India with that inthe OECD countries using EUKLEMS data.17 We distinguish Korea from the otherOECD countries, given its status, like India, as a late-developing, albeit higher incomeeconomy. Its data, therefore, provide something of a bridge between India and the restof the OECD.14 The rapid growth of trade and transport, which are placed in Group I on the basis of the experience of other countries, suggests that this is presumably an effect of post-1991 reforms.15 Interestingly, the share of GDP accounted for by personal and other services continues to rise strongly in the OECD countries, in contrast to India where it has been falling (for reasons not entirely clear to us). The services included in this segment are entertainment, recreation, T.V. radio, and personal services. Anecdotal evidence would suggest that with rising per capita incomes and an upcoming middle class, these services have grown quite rapidly. Jain and Ninan (2009) show that the entertainment and media sector has grown at around 19 per cent a year in the last few years. The declining share of these services in GDP could very well be a reflection of poor data.16 In the 1990s, modern services in fact contributed nearly as much to aggregate growth as agriculture or manufacturing. Since 2000, communications alone has contributed more to GDP growth than agriculture.17 The EU KLEMS release of 2008 spans the period 1970-2005 for the 15 founding (pre-2004) EU member states and for the US, South Korea, Japan and Australia. Series from 1995 onwards are available for the new EU member states that joined the EU on 1 May 2004. Industries are classified according to the European NACE revision 1 classification, but the level of detail varies across countries, industries and variables owing to differences in national statistical procedures. For our analysis, we do not include the new member states and further drop Luxembourg and Portugal. Thus, we use the data on Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Japan, Korea, Netherlands, Spain, Sweden, United Kingdom, and United States. 5

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While the share of Group I services is clearly still increasing in India, it has eitherstagnated or is in decline in the higher-income countries (Panel A of Figure 8). TheEUKLEMS data base does not extend back far enough to provide much evidence forthe period when the OECD countries had per capita incomes comparable to India’stoday, although the data for Korea suggest that the share of Category I services inIndia is in line with the international norm. Panel A clearly shows that the size ofGroup I activities started tapering off at a per capita income level of $3,000 in 2000PPP USD in South Korea (in 1974, when the share of Group I reached 28.2 per cent).This is close to India’s 2008 per capita income of roughly $2,900 (again in year 2000PPP dollars), as is the current share of Group I service in India (26 percent).Assuming that India continues to track the international norm, the share of Group Iservices is likely to stabilise before too many more years (assuming, inter alia, a realper capita income growth of five per cent). Retail trade is the main Group I activity with significant potential to grow, accordingto authors like Jain and Ninan (2009).18 This sector has been sheltered from foreigncompetition and remains dominated by mom-and-pop stores. Jain and Ninan andothers suggest that consolidation and increased competition from foreign retailershave the potential to increase significantly the sector’s contribution to growth.The share of Group II services is similarly unexceptional. International comparisonssuggest that some activities within this group, such as health care and education, haveconsiderable scope for expansion. It is widely acknowledged that India needs to investmore in education. For this to happen, however, the sector will have to beliberalised.19 Moreover, one can then imagine education and perhaps, health care,becoming net exporters, just as IT has become an export industry. The experience ofother countries suggests that a country becomes a net exporter of services likeeducation and health care only when its per capita income exceeds $5,000 (again inyear 2000 US purchasing power parity dollars), a level that will take India ten years toreach (assuming, again, a real per capita income growth rate of roughly five per cent).The last panel confirms that Group III services have been the fastest growing in Indiaand that their take-off began at much lower incomes than in the OECD countries.5. Accounting for Service Sector GrowthWe now distinguish growth attributable to the intermediate demand for service inputsfrom that attributable to final demand. Intermediate demand may simply reflect arecategorisation as service-sector employment of certain activities previouslyconducted in-house by manufacturing firms and which are now outsourced to theservice sector. Its dominance would imply a less favourable view of the netemployment creating potential of the sector.In equation 1, let S refer to value added in services, A to value added in agriculture, Ito value added in Industry, X to exports (i.e. the value added component in exports),ia,s to the input-output coefficient of agriculture for services inputs, and ii,s to the18 The other main activity in this group is public administration and defence, which seems to be declining (see above).19 A comprehensive analysis of the deficiencies in the Indian education system is in Panagariya (2008); an agenda for reform is in Kapur and Mehta (2008). 6

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input-output coefficient of industry for services inputs (both defined as the use ofservice input per unit of value added in agriculture and industry respectively) and C toconsumption, which is the residual (the difference between value produced and otheruses).20 Then:S = i a , s * A + ii , s * I + X + C (1)∆S ∆(i a ,s * A) ∆(ii ,s * I ) ∆X ∆C = + + + (2) S S S S S∆S A ∆A A I ∆I I ∆X X ∆C C = (∆ia ,s * ) + (ia , s * ) + ( ∆ii,, * ) + (ii , s s * )+( * )+( * ) S S A S S I S X S C S (3)Equations 2 and 3 tell us that, for given input-output coefficients, the growth ofservices equals the weighted average of the growth in various sectors, the weightsbeing the relative size of each sector relative to the size of the service sector as awhole. Beyond that, changes in input-output coefficients, whatever their cause, canalso affect the demand for services.Operationalising this framework requires data on services used in industry andagriculture, on the growth rates of value added in agriculture, industry and exports, onthe sizes of the respective sectors and on the growth of services themselves. We takeinput-output coefficients from the input-output matrices for India for 1993, 1998, and2003. The size and growth rate of each sector are available from the CSO, while datafor exports is available from the Reserve Bank of India. Final consumption is theresidual.21A. Intermediate Demand for Services. In Table 3, we calculate the use of servicesper unit of value added in agriculture and industry using input-output matrices for1993, 1998 and 2003. These calculations do not suggest that the intensity with whichservices are used in industry has changed much over time. The implication is thatgrowth in the intermediate demand for services from industry is due mainly toincreasing output rather than increasing outsourcing of in-house manufacturing-sectoractivities to the service sector.Combining the coefficients in Table 3 with value added growth in industry, we seethat intermediate demand from industry accounts for about a third of value added inservices. Since the coefficients have not changed much and since industry has grown20 Input-output coefficients are defined in terms of the use of domestically produced services per unit of value added in agriculture and industry. Thus, we first convert the input-output coefficients for per unit of output available from different input-output matrices into the coefficients for per unit of value added. We assume that the same coefficient applies to services domestically produced and to imported services for industry. We further assume that in agriculture, only domestically produced services are used. Export data are usually available in terms of value of output; we assume that the ratio of value added to value of output for export of services is the same as that for total services.21 We find that input-output coefficients are similar between 1993 and 2003 (the values are 0.68, 0.64, and 0.74 respectively in the years 1993-94, 1998-99, and 2003-04). We assume the value to be 0.70 during the sample period. The input-output coefficient for value added in agriculture changes little during these years and is assumed to be the same through the period at 0.07. 7

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more slowly than services, the share of value added in services accounted for byintermediate demand from industry has evidently declined (from 40 per cent in 1991to the 31 per cent in 2007).22 Similar calculations show that the share of services valueadded used in agriculture is just two per cent in 2007, down from five per cent in1991.By contrast, the share of services that are exported has risen strongly from about threeper cent in 1991 to ten per cent in 2007 (Figure 9). This is a clear indication thatexports and net domestic demand are the main sources of demand driving the growthof India’s service sector.23It is noteworthy that the analogous input-output coefficients have been stable in theU.S., while in other advanced countries, they rose until roughly 2000 and stabilisedsubsequently. However, rising coefficients did not necessarily translate into a highershare of value added for the service being used as an intermediate input.. Value addedin industry and agriculture is not growing fast enough to drive the overall growth ratesfor services. As Figure 10 shows, U.S. industry uses only about 15 per cent ofservices value added, and that share has declined further over the years. Exports alsoconstitute a relatively modest five per cent of U.S. value added in services (their sharehas been rising slowly). In the U.S., then, three-quarters of services are for finalconsumption.24Exports have contributed significantly to the growth of services in India and ofmodern Group III services in particular. India’s share in global exports of servicesrose from 0.8 per cent in 1998 to 1.3 per cent in 2003 and 2.7 per cent in 2006 (seeFigure 11). It is mainly modern services (referred to as “miscellaneous services” inthe Reserve Bank’s data) that have been driving this export performance (Figure 12).Further decomposing miscellaneous services into software, communication, businessand financial services reveals that exports are dominated by software services (Figure13).B. Contribution of Different Uses to Services Value Added Growth. Figure 14shows that growth of private final demand accounts for about half of the growth ofservice-sector output. The other half is split between exports and outsourcing byindustry, with exports of service accounting for a growing share in the last twodecades.2522 In Appendix D, we show the correlation between the growth rates in services and manufacturing. If indeed the intensity of use of services as an intermediate input were increasing, then we would see the correlation between services and manufacturing growth to be increasing over time. On the contrary, we find the correlation between growth in manufacturing and services to be declining overtime.23 As a robustness test, we use the average input-output coefficient for industry from the EUKLEMS countries to calculate the share of services used in industry in India. The overall pattern is found to be similar to the one reported here.24 The numbers are similar for the other OECD countries where, on average, services sector supplies about 18-20 per cent of its value added to industry and 1-2 per cent to agriculture.25 We divide the post-reform liberalisation period somewhat arbitrarily into three: 1991-1997, 1998- 2002, 2003-2007. The first period is the years after the reforms started when the GDP growth averaged 5.5 per cent and it was broad-based growth. Industrial growth slowed down during the next sub-period 1998-2002 (from 6.3 per cent in 1991-1997 to 4.5 per cent in 1998-2002) but exports of services were just picking up. Thus, based on the pickup in exports growth, the services sector continued to grow robustly even when industry was not in this second period. The last sub period, 8

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The thrust of these calculations is, thus, inconsistent with the claim that the growth ofthe service sector is just disguised manufacturing activity. Only a relatively smallfraction of the growth of demand for services reflects outsourcing frommanufacturing. Most production that does not go towards exports, in fact, derivesfrom final demand at home. As emphasised in our introduction, the growth of servicesector employment does more to add to total employment outside agriculture thanoutsourcing arguments would lead one to expect.6. Proximate Determinants of Service Sector GrowthWe analyse the proximate determinants of service sector growth with annual data fordifferent services for the period 1980-2006. We estimate an equation of the form:growthit = α (Size EUKLEMS, initial − size ind, t -1 ) + β PCYt + γ PCYt + 2η tradable services i + λ skilled labori + ρ liberalization i + τ correlation with ind i + ε it (4)The dependent variable is the growth in value added of service i in year t. The firstexplanatory variable is the difference between the share of service i in other countriesand India.26 This captures catch-up: the extent to which this activity is likely to growunusually rapidly if the initial share is unusually small because of, among otherthings, a heavy regulatory burden. Other explanatory variables are per capita income(in levels and squared), the tradability of the service in question, whether the sectorhas been liberalised, its skilled-labour intensity, and whether growth of the activity inquestion is correlated with industrial growth (as a proxy for outsourcability).27 Sincethe liberalisation index and size gap are highly correlated, we include them one at atime in the regressions.Results in Table 4 suggest that growth in services value added increases with percapita income.28 Consistent with the catch-up argument, the growth rate is higher forservices that have an unusually small share to begin with, measured against their sharein the advanced countries. For every one percentage point of GDP that the servicesshare is lagging, the growth is half per cent higher. Tradable services have grownfaster, other things equal, by four percentage points a year. Services that had a smallshare to begin with also seem to be the ones that were liberalised. Results show thatthe services which were liberalised have also grown faster. 2003-2007 is the one in which the services sector growth accelerated handsomely. The growth was aided by revival in the industrial sector (which grew at an average annual growth rate of 8.2 per cent), as well as growth in exports.26 The gap is calculated as the difference between the share of respective services in GDP in the EUKLEMS sample (in 1980 for the period up to 1989 and in 1990 for the period since 1990) and one-year lagged share in India.27 The correlation variable is based on the correlation coefficients between services growth and growth in manufacturing, calculated over different time periods. The correlation coefficients are consistently and significantly different from zero for three services: trade, hotels and restaurants and transport. Tradability is indicated by a dummy variable, which takes a value of one if the service is considered to be tradable and zero otherwise. This indicator is based on Jensen and Kletzer. Details are in Appendix C.28 While per capita income and per capita income squared are not individually different from zero, they are jointly significantly different from zero. 9

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All this has implications for policy. It suggests that policy makers should continue toencourage exports of IT, communication, financial and business services while alsoliberalising activities like education, health care and retail trade, where regulation hasinhibited the ability of producers to meet domestic demand.7. Employment in ServicesOne reason why some observers are unimpressed by the growth of the service sectoris the presumption that modern services do not make significant use of unskilled andsemi-skilled labour, the factor of production that India has in abundance. Theydownplay information technology and communications-related service sectoremployment on the grounds that these activities are small and use little unskilledlabour, the implication being that a labour-abundant economy cannot rely on them tomove people out of low-productivity agriculture.This hypothesis is untested, perhaps because little data is available for employment inservices by skill. In Table 4, we report employment elasticities from Rangarajan et al(2008), who calculate these from the NSSO data.29 As is evident from the table,service sector growth has, been, in fact, quite labour intensive and, in certainsegments, more so than manufacturing sector growth.Although these data do not allow us to say whether this is an increase in skilled orunskilled employment, evidence from other countries may shed light on this question(as does some anecdotal evidence described in the conclusion). Figure 15 plots theGDP share of different services for the 17 OECD countries.30 We again show Koreaseparately, as a middle-income OECD country that is in some sense intermediatebetween India and the high-income OECD countries. While the share of Group I(traditional services) in GDP has declined over time, its share in employment has not.Group II (hybrid) services have accounted for a growing share of GDP and an evenmore rapidly growing share of economy wide employment. Group III (modern)services have accounted for increased shares of both GDP and employment over time.Figure 16 looks at shares in hours worked by low skilled and high skilled workersseparately. Movements here mirror movements in relative labour productivity.Notably, for modern high-tech services, labour productivity exceeds labourproductivity economy-wide. This group of activities is similarly distinctive in thatthere is no sign of the gap relative to economy-wide labour productivity changingover time.We can estimate the elasticity of employment with respect to value added for 17OECD countries in the period 1970-2005, separately for each activity. Specifically,we estimate: Log Employmentit = α i + βLog Value Added it + ε it (5)29 NSSO data refer to the household survey data published by the National Sample Survey Organisation. The numbers we report are drawn from Rangarajn et al (2008).30 Again using the EUKLEMS data base. 10

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where αi refers to country fixed effects and t to year. As dependent variables, weconsider number of employees, number of hours worked and number of hours workedby skill levels – low-skilled workers, medium skilled workers or high-skilled workers(all in log terms). We calculate these elasticities with respect to value added inagriculture, manufacturing and different services by estimating different regressionsfor each sector separately.The results (Table 6) show that employment elasticities are highest in Group II andGroup III services. While they are higher for high-skilled than low-skilled workers,they are also positive and significant for medium-skilled workers across a wide rangeof services. They are highest of all in modern business services. The employmentelasticity for medium-skilled workers is in general about half the elasticity for highskilled labour and is positive for all service activities except agriculture.One might argue that India does not use the same technology as the advancedcountries analysed here. Given the relative endowments of labour and capital, Indiapresumably uses more labour and more unskilled labour, thus these elasticitiescalculated using the OECD countries would not be indicative. We, therefore, calculatethese elasticities using data only through 1995, the assumption being that technologylags in India by a decade. We find that the overall elasticities of employment aresimilar. However, the elasticities reported in the table are somewhat lower forunskilled labour and somewhat higher for skilled labour than in the period before1995.31We also estimate the regressions for employment elasticity with interaction terms forKorea on the grounds that it differs less than the others from India. Elasticities aresomewhat higher for Korea, in particular the elasticities for unskilled labour. This isconsistent with the notion that there is an economically significant demand forunskilled labour associated with the growth of the service sector in less advancedeconomies.Overall, we observe that the skill content of the labour employed in manufacturingand services is showing tendencies toward convergence. Manufacturing, like mostservice activities, has negative employment elasticity for unskilled labour hours, apositive but modest elasticity for mediums skilled labour, and a large elasticity forskilled labour. Thus, the skill content of both the manufacturing and services sectorsis increasing over time. It is not as if manufacturing employs only unskilled labourwhile modern services employ only highly-skilled labour. In fact, the skill mix oflabour employed in the two sectors is becoming increasingly similar. As emphasisedin the introduction, it is no longer obviously the case that manufacturing is the maindestination for the vast majority of Indian labour moving into the modern sector andthat modern services are a viable destination only for the highly-skilled few.8. ConclusionIndia is distinctive for the rapid growth of its service sector – high-tech informationtechnology, communication and business services in particular. However, whether theservice sector provides a route out of poverty for the masses and thus a path to31 Evidently, there has been some substitution away from unskilled labour over time. 11

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economic development is disputed. Some say that the high skill and educationrequirements of modern service sector jobs make them an impractical destination forthe rural masses. Others counter that as more skilled and educated workers “graduate”from manufacturing and traditional services, they open up economic space there forless educated workers capable of upgrading their skills. They argue that the skilled-unskilled mix of the manufacturing and service sectors, each taken as a whole, is notas different as commonly supposed. Some say that much non-traditional service sectoremployment is little more than the outsourcing (relabelling) of activities previouslyundertaken in-house by manufacturing firms. Others counter that much of the growthof service sector employment represents job creation as opposed to outsourcing.We find little evidence that the growth of the service sector simply disguisedmanufacturing activity. Although it is probably still the case that even the mostrudimentary jobs in the modern service sector, like basic data entry, require somehigh-school education (something possessed by only a third of the relevant cohort)while much employment in manufacturing does not, the data suggest that the skilled-unskilled mix of labour in the two sectors is becoming increasingly alike. It is nolonger so obviously the case that manufacturing is the exclusive destination for thevast majority of Indian labour moving into the modern sector and that modernservices are a viable destination only for the highly skilled few.While our analysis has been statistical, there is anecdotal evidence consistent withthese conclusions. Polgreen (2009) describes how modern service sector jobs are nowmigrating from India’s urban centres to its small towns and rural villages, creatingemployment for semi-skilled workers. While these workers may not have themathematical training to work as computer programmers or the English fluencyneeded for employment in call centres, with some high school education, they aresufficiently numerate and have adequate facility in English to “do basic data entry,read forms, and even write simple e-mail messages.” The wages of these rural servicesector workers are three to four times those available in agriculture but only half thoseof workers in Bangalore, where the competition for labour is more intense and livingcosts are higher. American trucking companies seeking to process their timesheets inIndia may not have the local knowledge to find rural workers to undertake the task butIndian companies like Rural Shores have been established to run service sectorfacilities in rural areas. These observations are consistent with the view thatemployment in modern service sector activity can be a route out of poverty not justfor the few and not just for urban residents. They are also consistent with theconclusion that employment in modern services can be a useful supplement toemployment in manufacturing as a route out of rural poverty.Sustaining economic growth and raising living standards, thus, will benefit fromshifting labour out of agriculture into modern services as well as manufacturing andnot just into the latter. To the extent that the expansion of both sectors continues to beconstrained by the availability of skilled labour simply underscores the importance forIndia to continue to invest in labour skills. 12

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Appendix A: Issues Related to Measurement and Quality of the NAS DataBosworth, Collins and Virmani (2007) provide a comprehensive account of thesources of growth in the Indian economy and its broad sectors since 1960 and lay outthe limitations of the sectoral GDP data and employment data in India. In particular,they express reservations about the quality of the data in activities that are conductedin the informal sector (called the unorganised sector). They also point out thepossibility that the data on price inflation for services is not reliable and indicate theshortcomings of the annual data for employment in services. Their overall assessmentis that the services sector growth is probably overestimated in India because the pricedeflator underestimates the inflation for services. The support for this thesis is foundin the growth of productivity in certain services segments, which are traditionallyknown to be low productivity growth sectors. Here, we comment on the quality of thedata used in our paper and the areas in which the data quality needs to be improved.Data on Value Added: Services activities are carried out in the organised as well asunorganised sectors. While the data on services produced in the organised sector isreliable, the data for services activities in the unorganised sector is not measureddirectly and is imputed using the labour-input method. This involves estimating thelabour input at the industry level (estimated as the difference between the measures oftotal labour input and labour input in the organised sector, obtained from quinquennialhousehold surveys and employer reports respectively) with measures of value addedper worker (obtained from enterprise surveys). Bosworth et al. rightly point out thatthese estimates can be reasonably prepared for the benchmark years in which thequinquennial surveys are carried out. Since annual estimates for the years between thesurvey years are obtained by interpolation, these are likely to be imprecise.While there is agreement that the measurement of value added in unorganised sectoris likely to be imprecise, the direction of the bias is not clear. The bias in the size ofthe various service sectors or growth rates can be upward or downward. Below weprovide some details on the methodology used in measuring the value added indifferent services and an assessment of the data quality. 15

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Appendix Table 1: Methodology used and Quality of Data on Services ValueAdded Services Methodology/quality of the Services Value Added Data Trade Since a large part of trade is in unorganised sector, the data quality may not be up to the mark for this sector. However, it is difficult to say whether the current practice results in the underestimation or overestimation of the size and growth of this sector. Unsurprisingly, the growth in this sector is closely related to the growth in manufacturing. Transport and Data quality is perhaps reasonable. Some of the main components Storage of the transport sector are measured accurately including railways, air transport, organised road transport, and organised water transport. The main activities where the measurement can be improved is in unorganised road transport. Public Data are likely to be reliable Administration and Defence Hotels and Since a large segment of this sector operates in the unorganised Restaurants sector, data quality may not be very good. These activities, however, constitute a very small part of the services sector and are unlikely to cause an upward bias to the overall services sector growth. Education, Since a lot of these activities are in the unorganised sector, the data health, quality may not be very good. However, one cannot say a priori other services whether the size and the growth of these activities are underestimated or overestimated. Underreporting possibly is a reason why this sector seems small in India as compared to the cross-country average. Communication Since a large share is either in the public or the organised private sector, the data quality is likely to be good. Banking Since a large percentage of the banking activity is carried out in the organised sector, the data quality is likely to be reasonable. Business Since a lot of the modern business services such as chartered Services accountancy, legal services, technical services, advertising, construction design etc. are carried out in the unorganised sector, these are probably not captured well in the estimation of value added. The error is likely to be on the downside and the size and growth of these activities are likely to be underestimated. Many of these activity providers now pay taxes and the tax returns could be one way to improve the quality of the data.Our assessment based on the methodological description and comparison with cross-country averages is that data collection needs to be improved for unorganised trade,unorganised road transport, unorganised business services, and unorganisededucation, health and personal services. For the latter two, the information on tax aswell as expenditure surveys might be useful to improve data quality. A priori, it isdifficult to say whether the activities in these segments are under or over reported, and 16

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it is possible that the size and growth of education, health, personal services, businessservice and other services are currently being underestimated in India.Below, we compare the growth rates for selected services calculated using the CSOdata with those calculated using the data from alternative sources (for the latter werely on Jain and Ninan (2009)). The sectors include retail, entertainment, IT,transport, and education. The table below shows that the growth for the last few yearsor that projected for the coming few years using alternative data sources is at par orhigher than that calculated using CSO data.Appendix Table 2: Comparison of Growth Rates of Services using the CSO Dataand the Data From Other Sources (in per cent) CSO Other Sources Retail 7.7 (in 2006) 13 (a) (projected annual growth rate in 2006-2011) 8 (b) (projected annual growth rate in 2008-2015, Technopak) Media and 2.8 (average of radio, 18 (c) entertainment broadcasting, entertainment, recreation between 2004-2007) IT Industry 19.4 (annual average 30 (d) growth rate of computer services between 2004- 2007) Education 7.2 (annual average ?? between 2000-2006)Sources: a. Projected growth of retail business, ICRIER’s retail study. b. based on the projected size of the Indian retail industry in US $ between 2008 and 2013, Technopak. c. Projected growth 18 per cent a year between 2008-2012. Source Jain and Ninan (from FICCI Frames). d. Calculated using the data on the size of the IT industry between 2004-2007 in US $ from Nasscom, reported in Jain and Ninan.Deflators: Bosworth et al (2007) raise the possibility that the inflation for certainservices, especially traditional services, is currently underestimated in India. Wecompare the deflators used for services sub-sectors relative to the deflator formanufacturing for India (deflators for India are based on the 1999-00 data seriesprovided by the CSO, calculated using current and constant prices values) with theaverage of the OECD countries for which the data are available in the EUKLEMSdatabase.These are shown in Figure A1. The index of relative deflators takes a value 100 in1980. For all the services (except banking), the deflator has grown either faster or atthe same pace in India as in the OECD countries. On the basis of this comparison with 17

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E: Banking 1.1 1 .9 .8 1980 1985 1990 1995 2000 2005 year Banking/Mfg, EUKLEMS Banking/Mfg, India Note: Data for India is from CSO and for OECD countries from the EUKLEMS.Employment Data: Finally, the data for employment in services is not readilyavailable even for organised activities. Researchers often use the National SampleSurveys (NSS) to get estimates of employment in services. These surveys areavailable every five years, data from which are interpolated to get the annual dataseries. But, as cautioned by Bosworth et al, these data are more reliable only for theyears in which the surveys are carried out, but not in the other years.Some data on employment for India are available in the Economic Censuses, whichhave been conducted by the Ministry of Statistics and Programme Implementation,Government of India in 1977, 1980, 1990, 1998 and 2005. These cover non-agricultural enterprises, and use the enterprise as the unit of enumeration. 20

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Appendix B: Data SourcesAppendix Table 3: Sources of DataVariable Data sourcePer Capita income Eichengreen and Gupta (2009) for data until 2004. We updated the data for 2005, 2006 using the latest version of the WDI and for India for 2005, 2006 and 2007 using the CSO.Share of services in GDP Eichengreen and Gupta (2009) for data until 2004. We updated the data for 2005, 2006 using the latest version of the WDI and for India for 2005, 2006 and 2007 using the CSO.Disaggregated services value added For India latest data from CSO, for cross country from the EUKLEMS data, downloaded from: www.euklems.netInput output matrices CSOExports and imports of services World Development IndicatorsDetailed data on Exports and imports of Reserve Bank of India’s website:services for India www.rbi.org.inEmployment for OECD countries EUKLEMS’s website: www.euklems.netEmployment data for India Economic CensusesDeflators for India Calculated using the current and constantDeflators for OECD countries price series for value added from CSO EUKLEMS 21

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Appendix C: Construction of Services CharacteristicsAppendix Table 4: Different Services Characteristics Sector Tradable Correlated Skill Skill Liberalization with Mfg Intensity Intensity Index Dummy Trade 0 1 9.1 0 0.25 Hotels and 0 1 6.1 0 1 Restaurants Transport, storage 0 1 6.7 0 0.5 Communication 1 0 9.2 0 1 Banking, 1 0 21.6 1 0.5 Insurance Business Services 1 0 26.7 1 1 PAD 0 0 22.4 1 0 Education 0 0 43.9 1 0.5 Health and Social 0 0 24.6 1 0.5 WorkSources and Construction of Characteristics: Tradability is indicated by a dummy variable,which takes a value one if the service is considered to be tradable and zero otherwise, seeEichengreen and Gupta (2009) for details.The dummy for correlation with manufacturing is based on the correlationcoefficients between services growth and growth in manufacturing, calculated overdifferent time periods. The correlation coefficients are consistently and significantlydifferent from zero for three services; trade, hotels and restaurants, and transport. Wealso look at the input output matrices over the years to see the data on outsourcing tothese services from manufacturing and find that trade, transport and banking have thelargest coefficients, but the hotels and restaurants industry does not have a largecoefficient. Thus, we construct this dummy in another way as well, when it takes thevalue 1 for trade, transport and banking services, and zero for other services. Resultsdo not change when we do that.Liberalisation Index is based on Cain et al (2009). They divide different sectors of theeconomy into least liberalised, moderately liberalised and significantly liberalised.We give a numeral score of 0, 0.5 and 1 respectively to these categories. Cain et alwork at a more disaggregated level, so in a few cases, services within the broadcategories that we use here belonged to different categories. In such cases, we take asimple average of the numeral scores for the services in the same broad category thatwe use. 22

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Appendix D: Correlation Between Growth Across SectorsBelow we conduct additional tests to see if the correlation between the growth rates inservices and manufacturing has increased or not. If indeed the intensity of use ofservices is increasing as an intermediate input, then we should see the correlationbetween services and manufacturing growth to be increasing over time.Appendix Table 5: Correlation Between Growth in Services and Other Sectorsin India I II Period b/w Services Growth and b/w Services Growth and Manufacturing Growth Agriculture Growth 1951-1965 .77*** .22 1966-1980 .59** .49* 1981-1995 .55** -.25 1996-2007 .26 .14Note: *, **, *** indicate that the correlations are significant at 1, 5, and 10 per cent levelsrespectively. Authors’ calculations using the data for India from CSO.Appendix Table 5 shows that the correlation between growth in manufacturing andservices has been decreasing overtime. These correlations confirm the pattern that wesee in the input-output matrices and imply that the growth momentum in services inrecent years has been independent of the momentum in manufacturing.Table 6 below shows the correlation between growth of specific services and thegrowth of manufacturing. For some of the traditional services such as trade andhotels, the correlation is relatively high though falling over time. Interestingly, thegrowth of modern services such as communications, business services and financialservices is not correlated with the growth of value added in manufacturing. Again,this implies that these services have a growth momentum of their own which does notsimply derive from outsourcing by manufacturing.32Appendix Table 6: Correlation between Growth in Services sub-sectors andManufacturing in India Trade Transport Hotels Communication Business Banking Services 1951-1965 .86*** .33 .67*** .45* .31 -.14 1966-1980 .52** .01 .49* -.15 -.05 .59* 1981-1995 .82*** .39 .37 .41 .53** -.16 1996-2007 -.05 .71** .40 .23 -.41 -.004Note: *, **, *** indicate that the correlations are significant at 1, 5, and 10 per cent levelsrespectively. Authors’ calculations using the data for India from CSO.32 The input-output coefficient is also the largest for trade, followed by transport. 23

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Figure 3: Services Sector Share in GDP and Log Per Capita Income 1950-1969 1970-1989 80 60 40 20 6 7 8 9 10 1990-2006 80 60 40 20 6 7 8 9 10 Linear prediction IndiaNote: The charts extend the analysis in Eichengreen and Gupta (2009) through 2006. The estimatedrelationship is based on a regression of share of services in GDP on a quartic polynomial in log percapita income, and country fixed effects. The regressions allow for a different intercept in the threeperiods indicated and different slope parameters in 1990-2006. Figure 4: Industry’s Share in GDP and Per Capita Income 1950-1969 1970-1989 40 30 20 10 6 7 8 9 10 1990-2006 40 30 20 10 6 7 8 9 10 Log Per Capita Income Linear prediction IndiaNote: The charts extend the analysis in Eichengreen and Gupta (2009) through 2006. The estimatedrelationship is based on a regression of share of industry in GDP on a cubic polynomial in log percapita income, and country fixed effects. The regressions allow for a different intercept in the threeperiods indicated and different slope parameters in 1990-2006. 25

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Figure 8: Size of Different Service Activities and Per Capita Income-Cross Country Experience and India A: Group I 30 Share of Services in Group I 10 20 0 6 7 8 9 10 Log Per Capita Income Share of Services in Group I Share of Group I in India Share of Services in South Korea B: Group II 30 Share of Services in Group II 10 20 0 6 7 8 9 10 Log Per Capita Income Share of Services in Group II Share of Group II in India Share of Services in South Korea C: Group III 30 Share of Services in Group III 10 20 0 6 7 8 9 10 Log Per Capita Income Share of Services in Group III Share of Group III in India Share of Services in South KoreaNote: Cross-country data is from the EUKLEMS database, and the data for India is from the CSO. 29